XYZ corporation exists for only one year, has no assets-in-place and no debt, and currently has access to two (mutually exclusive) potential projects. In order to fund either project, XYZ must obtain outside debt- financing. The choice between the projects is determined after debt financing is in place, and creditors cannot control the choice of project once they have agreed to provide funds. The decision regarding projects is made by managers who act purely in the interest of equity holders.

Project R costs $50 million today, and pays, with probability 1/2 each, either $400 million or $0 in one year.

Project S also costs $50 million today, and pays either $300 million, or $250 million, or $150 million with probability 1/3rd each.

Throughout this problem, assume that if equity holders are exactly indifferent between Project S and Project R then they choose Project S. Also assume throughout that any excess cash generated by financing activities (i.e. any amount that cannot be immediately invested) is immediately paid out to equity holders. Finally, assume that the discount rate is 0 for all cash-flows.

a. Suppose XYZ raised money by issuing debt with a face value of $100 million due in one year. How much are creditors willing to pay for this debt issue? Is it enough to cover the investment needs of XYZ?

b. Suppose instead that XYZ raised money by issuing convertible debt with a face value of $100 million due in one year, convertible into 1/3rd of the (post-issue) equity in one years time, should debt-holders choose to convert. How much are creditors willing to pay for this debt issue? Is it enough to cover the investment needs of XYZ?

c. Based on your answers to (a) and (b) discuss who (debtholders vs equityholders) is better off and when? Give some clear and precise intuition for your findings.